COMMENTS HIGHLY APPRECIATED AN EMPIRICAL TEST OF THE DUTCH DISEASE ...

61 Pages·2003·0.26 MB·English

COMMENTS HIGHLY APPRECIATED
AN EMPIRICAL TEST OF THE DUTCH DISEASE HYPOTHESIS
USING A GRAVITY MODEL OF TRADE
Accepted for presentation at the 2003 Congress of the EEA, Stockholm, August 20 to August 24.

*
JEAN-PHILIPPE STIJNS
University of California at Berkeley, Department of Economics

First draft: September 2002. Current draft: May 2003.

JEL: F12, F41, O13, Q33
Keywords: Dutch disease, resource booms, gravity model, manufacturing exports, energy, trade, industry.

Abstract
Although the core model of the Dutch Disease makes unambiguous predictions regarding
the negative effect of a resource boom on a country’s manufacturing exports, the
empirical literature that has followed has not clearly identified this effect. I attribute this
to the failure of the existing literature to combine enough data to produce a sufficiently
powerful and exogenous test. I will use the World Trade Database to systematically test
this hypothesis in a gravity model of trade. World energy prices are used to bypass issues
of endogeneity regarding primary exports. A one percent increase in world energy price
is estimated to decrease a net energy exporter’s real manufacturing exports by almost half
a percent. Similarly, after instrumentation, a one percent increase in an energy exporting
country’s net energy exports is estimated decrease the country’s real manufacturing
exports by 8 percent. The corresponding confidence intervals are tight and these results
are shown to be quite robust.

*
I am grateful to George Akerlof, Brad DeLong, Chad Jones, Maury Obstfeld, David Romer, Andy Rose,
Emmanuel Saez, Ragnar Torvik, and Brian Wright for very valuable discussion and suggestions. They
cannot be held responsible for any of the opinions expressed here nor for any remaining errors. I have also
benefited from presenting this research in various seminars at the Catholic University of Louvain,
Northeastern University, the University of California at Berkeley and the University of Essex. I thank
Tamara Springsteen for helpful editing.
Correspondence: [email protected]; University of California, Department of Economics, 549 Evans
Hall #3880, Berkeley CA 94720-3880.
© Jean-Philippe Stijns. All rights reserved.
AN EMPIRICAL TEST OF THE DUTCH DISEASE HYPOTHESIS
“[…] in the words of Lord Kahn [1905-1989], ‘when the flow of North
Sea oil and gas begins to diminish, about the turn of the [21st] century,
our island will become desolate.’ Any disease which threatens that kind
of apocalypse deserves close attention.”
“The Dutch Disease,” The Economist, November 26, 1977: pp-82-83.
1 Introduction
It is widely assumed in the literature that natural resource booms tend to harm the countries in which they
occur. Most famously, Sachs and Warner (1995) show that economies with a high ratio of natural resource
exports to GDP in 1971 tended to have low growth rates during the subsequent period 1971-89. This
negative relationship holds true after controlling for other usual determinants of economic growth, such as
initial per capita income, trade policy, government efficiency, and investment rates.
Sachs and Warner (1995) conclude that “one of the surprising features of modern economic
growth is that economies abundant in natural resources have tended to grow slower than economies without
substantial natural resources.” Such a statement deserves careful scrutiny if only because of its
implications for both development policy in the third world, and for macroeconomic policy in
industrialized countries. At the same time, there is a growing debate among academics, development and
environment related lobbyists and policy makers regarding whether or not resource abundant countries
should be encouraged to exploit their resource bases.
A growing literature is dealing with an increasing number of aspects of the “resource curse”.
There are two main areas of active research1. The first can be termed the “political economy of mineral
rent generation and distribution.” The second covers the “general equilibrium effects of a minerals boom”,
including the spending effects of the mineral rents. This paper focuses on this second literature and what is
probably the best-known and the most classical formulation of the resource curse hypothesis, namely the
Dutch Disease — hereafter DD — hypothesis.
In a nutshell, the DD primarily refers to a situation in which a booming export sector increases the
relative price of non-tradable goods and services, thus hurting the rest of the tradable goods sector. Its
name arose from the effects attributed to the discoveries of North Sea gas on the Dutch manufacturing
sector. Corden and Neary (1982) present what has come to be known as the “core model” of DD

1 The terminology hereafter is adopted from Daniel (1986).
Page 2 of 43
AN EMPIRICAL TEST OF THE DUTCH DISEASE HYPOTHESIS
economics. In this paper, I test systematically one of its main unambiguous testable hypotheses, one that
has generated the most concern among economists, the hypothesis that resource booms lead to reductions
in manufacturing exports, controlling for all other determinants of trade.
There is a large literature on the empirics of the Dutch Disease. This literature is mostly a
collection of country — sometimes comparative — case-studies for the OECD and developing countries.
Spatafora and Warner (1999, 2001) is the only exception. Their dataset is composed of 18 oil-exporting
developing countries covering a period running from the mid sixties to the eighties. They find that Dutch
Disease effects are “strikingly absent” from their data. However, there exists, to the best of my best
knowledge, no generalized cross-country econometric test of the consequences of resource booms on real
manufacturing trade.
The general conclusion of this literature is that there are symptoms of the Dutch Disease in most
instances of a commodity boom but that it is very difficult to disentangle DD effects from the domestic and
international macroeconomic conditions prevailing at the time of the shock. Price led energy booms tend to
be accompanied by (world-wide) recessions. Hamilton (1983) is known to have most convincingly isolated
this pattern for the United States and provides evidence that we can still expect this pattern to be at work
(Hamilton, 1996). Rotemberg and Woodford (1996) propose an explanation for the surprisingly strong
elasticity of output to oil prices — a 10% oil price innovation is associated, five or six quarters later, with a
2.5% decline in output — based on imperfect competition in product markets.
I use a gravity model of manufacturing trade to control for the macro-economic circumstances
faced at home and by trade partners, as well as other important geographic determinants of trade. The
choice for this particular model is due to its excellent empirical track record and its theoretical consistency
with a variety of different views of trade. This last characteristic will exempt me from having to adhere to
any particular such view of trade. In other words, I use the gravity model of trade as a reduced form of a
potentially more complex structural model that I leave unspecified.
Acknowledging the potential endogeneity of commodity exports to manufacturing trade, the world
price of energy — in real terms — is used to identify price led oil booms. Indeed, the world energy price
can be safely assumed to be exogenous to any single country’s manufacturing exports. Yet these world
Page 3 of 43
AN EMPIRICAL TEST OF THE DUTCH DISEASE HYPOTHESIS
prices are highly correlated with domestic energy prices, and thus changes in value added in the energy
sector. They are therefore an ideal instrument variable for energy booms.
Corden (1984) points out that a resource boom can take place in three different ways: first, there
can be exogenous technological progress in the booming resource sector; second, the country can see a
windfall discovery of some natural resources; third, there can be an exogenous rise in the world price of a
natural resource exported by a country. In this paper, I focus on this third kind of natural resource boom.
Similarly, there are potentially other forms of booms associated with types of commodities other than
energy. This, of course, implies that there are potential cases of Dutch Disease that this paper will
overlook. Since the purpose is to show the existence of at least some form of Dutch Disease, I simply leave
the identification of other forms of Dutch Disease as interesting paths for further research. Future research
will have to determine whether other types of booms and booms associated with other kinds of
commodities have similar effects to those identified here, if any.
With this identifying assumption in hand, two types of elasticities are estimated. First, the real
energy price elasticity of manufacturing exports in net energy exporting countries is estimated to be, on
average, close to minus ½. In other words, a 1% increase in the price of energy will, everything else held
constant, decrease a net energy exporter’s real manufacturing exports by half a percent. Second, the net
energy export elasticity of manufacturing exports, when instrumented by world oil prices, is minus 0.08. In
other words, a 1% increase in net energy exports will, everything else held constant, decrease a net energy
exporter’s real manufacturing exports by one eighth of a percent. These elasticity estimates are very
significant, and the corresponding confidence intervals are tight.
I conduct extensive sensitivity analysis and these “benchmark” results turn out to be quite robust.
They are robust to the introduction of country specific fixed effects on top of country pair fixed effects.
This eliminates the concern for the corresponding type of omitted variable bias. Censored tobit regressions
reveal that results are not dependent on the presence or treatment of small export observations. Results are
also robust to changes in the currency unit of measurement. Outlier analysis reveals that results are not
significantly dependent on any country or country pair. Further, the main conclusions of this paper are not
dependent on the inclusion of any geographical group of countries, or set of countries characterized by a
specific type of effective exchange rate regime.
Page 4 of 43
AN EMPIRICAL TEST OF THE DUTCH DISEASE HYPOTHESIS
In contrast with the existing literature, I find strong evidence of the DD in the world trade data.
Price-led energy booms, systematically tend to hurt energy exporters’ manufacturing exports. This paper
dispels doubts about the empirical relevance of the DD. It is intuitive, after all, that when juxtaposing the
marginally convincing evidence found in numerous countries, one be able to either reject or accept the DD
hypothesis2.
One should be careful not to over-interpret the results reported in this paper, however. In most
cases, booms result in increased GDP levels, and hence increased welfare, for energy producers. This is not
the question in this paper. Further, one only needs to worry about the DD insofar as there is indeed
something desirable about having a large proportion of manufacturing exports. There is, indeed, evidence
that productivity growth can sometimes be very strong in resource extraction industries, both in
industrialized and developing countries. In addition, the role that manufacturing plays vis-à-vis the primary
sector can vary from country to country, for example, because of factor intensity reversal.
On the other hand, there is a widespread assumption in the structural tradition of the development
literature that industrialization should be per se a development goal. More recently, Matsuyama (1992),
Sachs and Warner (1995, 1999), and their followers, have explicitly modeled economic growth as a
function of the relative size of the manufacturing sector. It is not the purpose of this paper to settle this
issue. Rather, the statistic and economic significance of the result found here leads me to argue in favor of
careful future empirical testing of the effect on productivity of sectoral changes in output and exports
resulting from energy and other resource booms.
This paper is organized as follows. Section 2 reviews the theory and empirics of the Dutch
Disease. Section 3 describes the methodology and data. Section 4 presents the main results. Section 5
proceeds with sensibility analysis followed by Section 6 that reports on outlier analysis. I conclude in
Section 7.

2 If authors in the DD empirical literature systematically reported comparable estimates of the effect of
resource shocks on manufacturing exports, it would be interesting to see if the same conclusion is reached
through meta-analysis. Such is far from the case, unfortunately.
Page 5 of 43
AN EMPIRICAL TEST OF THE DUTCH DISEASE HYPOTHESIS
2 Literature Review
2.1 The Dutch Disease theory
The DD refers to a situation in which a boom in an export sector leads to a shift of production factors
towards the booming sector and an increase in the prices of non-tradable goods and services, thus hurting
the rest of the tradable goods sector. Its name arose from the effects presumably caused by the discoveries
of North Sea gas on the Dutch manufacturing sector. Corden (1984) notes that the term appears to have
been coined in The Economist of November 26, 1977.
Dorrance and Leeson (1997) trace the idea itself back to Meade. Meade spent six months in
Australia in 1956. While there, he observed the effect of growth in Australia's resource exports, and
identified what came to be called the DD (Corden, 1996). The first paper approaching this question is
actually by Meade and Russell (1957). Corden (1984) and Corden and Neary (1982) are the cornerstones
of a vast DD literature that developed around how a natural resource boom can trigger a process of “de-
industrialization”3.
Corden and Neary (1982) present what they call and what has come to be known as the “core
model” of Dutch Disease economics4. They assume a small open economy that produces three goods: two
are traded at exogenously given international prices; the third is a non-traded good whose price is
determined by domestic supply and demand. The traded goods sector includes a booming good, and a non-
booming one. The non-traded good is typically thought to be produced by the service sector (but it can be
extended to the construction sector, etc). The main model assumes capital to be sector specific whereas
labor is assumed to be mobile. A resource boom affects the rest of the economy in two main ways: the
“resource movement effect” and the “spending effect”.
On the supply-side, an exogenous increase in the value of the booming sector’s output raises the
marginal product of labor in that sector. A shift of labor to the booming sector from all other sectors will
ensue and a contraction of the tradable sector will result from its reduced use of production factors. This is
the resource movement effect. This factor movement also leads to an increase in the price of non-traded

3 See Corden (1984) for a review of the early DD literature written in the 1970’s.
4 The presentation made in this section of the “core model” of the DD is inspired from two very clear
presentations by Adolfo Meisel Roca (1999) and Karlygash Kuralbayeva, Ali M. Kutan and Michael L.
Wyzan (2001).
Page 6 of 43
AN EMPIRICAL TEST OF THE DUTCH DISEASE HYPOTHESIS
goods since, ex ante, it results in excess demand for non-tradables. Since the price of tradables is
exogenously determined in world markets, the rise in the prices of non-tradables is equivalent to an
appreciation of the real exchange rate.
On the demand side, the boom, leads to increased income at home and therefore, to increased
demand for all goods. Since the price of tradables is set on world markets, this extra spending raises the
relative price of non-tradables, resulting in a further appreciation of the real exchange rate. In response,
labor shifts from the tradables sector to the non-tradables sector resulting in a contraction of the non-
booming tradables sector. This is the spending effect.
With one specific non-mobile factor (capital) and one mobile factor (labor) in all sectors, both the
resource movement effect and the spending effect imply a shift of labor away from the manufacturing
sector, resulting in an unambiguous decline in manufacturing output5. The booming sector’s output
increases since the value of output initially increases, and it absorbs ex post production factors coming from
other sectors. There is ambiguity regarding the change in non-tradable output. The spending effect implies
an expansion of this sector, yet the resource movement effect implies a contraction.
The strength of the spending effect depends on the propensity to consume services. Typically,
when a resource boom occurs, increased government spending on construction and public services is likely
to be the main channel for use of mineral rents. Mineral states have been documented to lavishly spend
their mineral revenues on numerous development projects and programs (see for example William Ascher,
1999). Hence, this marginal propensity to consume non-tradables will be high. The strength of the
resource movement effect depends on the factor intensity of each sector. If the booming resource sector is
the capital intensive sector — as is often the case in LDCs as well as in more industrialized countries, albeit
to a lesser extent — the spending effect will dominate the resource movement effect.
Corden and Neary (1982) call “direct deindustrialization” the movement of labor from the
manufacturing sector to the booming sector. The flow of labor out of the non-tradable sector, together with
the increased demand for goods from that sector due to the spending effect, causes a further shift of labor

5 Corden and Neary (1982) show the implications of two other sets of assumptions about factor mobility
between sectors. One can assume that capital is mobile between the manufacturing and services sectors, or
that capital is mobile among all three sectors. In these cases, resource allocation cannot be determined
without a prior knowledge of parameter values. In the rest of this paper, given the lack of unambiguous
predictions from the models with mobile capital, the DD model will refer to the basic model with one
specific non-mobile factor (capital) and one mobile factor (labor).
Page 7 of 43
AN EMPIRICAL TEST OF THE DUTCH DISEASE HYPOTHESIS
from the manufacturing sector to the non-tradable sector. They refer to this second shift as “indirect de-
industrialization”. For reasons related to those mentioned above, indirect industrialization is expected to be
more important than direct deindustrialization.
When the net effect of the spending and the resource movement effects are considered together,
we obtain the following 4 main results:
(R1) The real exchange rate unambiguously appreciates6;
(R2) There is a likely though theoretically ambiguous increase in non-traded output;
(R3) Production in the manufacturing sector unambiguously falls;
(R4) There is a fall in manufacturing exports.
There are thus three unambiguous testable hypotheses. I do not test for R1. Instead I refer the reader to a
recent contribution by Chen and Rogoff (2002). They show R1 holds for the few mineral-rich countries
they select for their data availability (even though that’s not enough to solve the PPP puzzle).
In theory, both R2 and R3 are testable hypotheses but sectoral production data is available in
reliably comparable form for only a few countries (mostly the OECD). Regarding R2, there is little doubt
throughout the DD literature that service output rises in response to resource booms (see Spatafora and
Warner, 1999 and 2001 for the most systematic results). In any case, testing an ambiguous implication of a
model is unavoidably less attractive because it does not allow inferences regarding the general validity of
the theoretical model itself. In other words, finding supportive as well as dismissive evidence regarding R2
would both be compatible with the DD model.
In this paper, I will only test explicitly for R4, principally because of the richness of trade data
compared to the scarcity and unreliability of manufacturing production data comparable across countries.
Under the hypotheses of the DD model, R3 implies R4, but it possible to imagine R4 without R3. In other
words, domestic production of manufactured goods could increase as a result of a resource boom while
manufacturing exports would decrease: the hypothesis tested in this paper, R4, is necessary but not
sufficient for R3.
For this to happen, domestic demand for manufactured goods would have to grow more than
exports would have to shrink as a result of a resource boom. Exports will turn out to be too strongly

6 This can take the form of a nominal appreciation or a change in the domestic : foreign aggregate price ratio.
Page 8 of 43
AN EMPIRICAL TEST OF THE DUTCH DISEASE HYPOTHESIS
affected by resource booms for this to be plausible. Had manufacturing exports only been marginally
affected by resource booms, the dichotomy between manufacturing production and exports would have
been more important to highlight.
In any case, many authors argue that international trade leads to firm-level learning about foreign
technology and markets; and so, independent of production, manufacturing exports slumps are often
perceived as a concern of their own. MacGarvie (2002) provides evidence of such learning effects using
patent data citations. Frankel and Romer (1999) instrument trade across countries with geographic
variables, and observe that trade has a positive effect on income. They conclude that their effect is
economically significant and robust, albeit marginally significant from an econometric point of view.
Finally, it should be noted that the DD effects discussed here are, of course, working on top of the
rest of the shocks affecting the economy. Specifically, declines in manufacturing exports in response to a
resource boom have to be thought of against the background of their counterfactual. The importance of a
“ceteris paribus” analysis will be illustrated when graphical evidence is examined, and will be further
justified by an examination of the empirical DD literature.
2.2 Existing Empirical literature
What about the empirical relevance of the DD hypothesis? There are two branches to this literature. One
covers resource-booms in OECD countries. Corden (1984) surveys the early empirical literature on
industrialized countries. A general book referring to the “oil or industry” issue with respect to Canada,
Mexico, the Netherlands, Norway, and Britain was edited by Barker and Brailovsky (1981). The other
branch of the empirical DD literature studies resources booms in developing countries. This second branch
succeeded the other although there is some overlap. McMahon (1997) reviews the results of eight different
studies focusing on developing countries.
In general, the development side of this literature tends to put more emphasis on rent-seeking
behavior and poor governance whereas the original literature focuses more on prices and structural issues.
This can be explained in part by the differing concerns each group of authors have. In OECD countries, the
concern is about ‘de-industrialization’ and the “ballooning role of the state”; many of these papers were
also written in an era when economists were responding to the worry that the United States was turning
Page 9 of 43
AN EMPIRICAL TEST OF THE DUTCH DISEASE HYPOTHESIS
into “a nation of hamburger flippers”, a process sometimes referred to as “servicesation”. Regarding
developing countries, in the relative absence of industry, development economists are more concerned with
‘de-agriculturization’ and detrimental effects on burgeoning social and political infrastructures of newly
decolonized nations in particular. I review each literature briefly in turn.
The Netherlands
In the late 1950s a very large deposit of natural gas was discovered in the north of The Netherlands.
Development began in 1963 and by 1977 a country which had traditionally been an energy importer
became an energy exporter. For Ellman (1981), cheap domestic energy seemed wholly favorable to the
economy, at least into the late 1960s and early 1970s. But during the 1970s, the guilder appreciated relative
to most currencies. The textiles and clothing industries almost vanished. There was a decline in metal
manufacturing, mechanical engineering, vehicles, ships, and even construction and building materials. The
service sector expanded noticeably, and seemed to be “taking over.”
Corden (1984) argues that “the true DD in the Netherlands was not the adverse effects on
manufacturing of real appreciation but rather the use of booming sector revenues for social service levels
which are not sustainable, but which have been politically difficult to reduce.” Barker (1981) and Kremers
(1985) conclude that it is difficult to “accuse” the gas discoveries of causing the severe decline in several
Dutch manufacturing industries between 1973 and 1977. Most of Western Europe was having a similar
experience, most specifically Germany, the main trading partner of The Netherlands. These countries were
also witnessing substantial growth in unemployment.
Figures I and II help compare the experience of The Netherlands with that of its trading partners.
Generally, periods of increasing real energy prices correspond to periods of shrinking manufacturing
exports as a share of GDP. Conversely, real energy price crunches correspond to periods of increases of the
share of manufacturing trade intensity. However, the pattern observed in The Netherlands looks very
similar to that of France and Germany which are not net energy exporters.
Figure II plots manufacturing exports for the same four countries in real 1995 dollars, i.e. the real
exchange rate index is applied to these series in order to capture the volume of manufacturing exports in the
local currency equivalent. Here again the Dutch experience is very similar to that of its main EC trading
Page 10 of 43